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Global: A Penchant for Optimism
Stephen Roach (New York)
The legacy of five fat years is an enduring feature of our times. Notwithstanding the post-bubble devastation of the New Economy -- not just in Nasdaq but also in its downwardly revised productivity and earnings underpinnings -- there’s a deep belief that’s it’s still possible to recapture the magic. Just a hint from Cisco of some "stability" -- whatever that means -- was enough to rekindle the spirits of yesteryear. Never mind the company’s poor forecasting record. The broad consensus of investors simply does not want to let go of the surreal glory that shaped the latter half of the 1990s. And most of the seers with whom I share my platform are more than happy to offer an obliging endorsement of this optimism. Since the worst is over, goes the argument, the best must be just around that proverbial corner.
As near as I can tell, the case for the coming rebound in the US economy rests on five key premises -- the time-honored upside of the inventory cycle, monetary easing, fiscal stimulus, lower energy prices, and the imperatives of the IT replacement cycle. Putting these forces together, the consensus believes it’s only a matter of time before the vigor of economic recovery rewards patient but battered investors. I still find myself on the other side of this line of reasoning. Not only do I believe that present circumstances threaten to undermine many of the seemingly classic building blocks of economic recovery, but I see several additional depressants that are being overlooked. Consider the following:
First, this inventory cycle lacks the classic pyrotechnics that have given rise to sharp production snapbacks in the past. Sure, the liquidation of stocks is a transitory event -- once its has gone far enough, output must be adjusted upward to stabilize depleted inventories. It’s like pushing down on a tightly coiled spring. The bigger the overshoot on the liquidation side of the inventory cycle, the larger the subsequent rebound. Yet by any standard of the past, this has been a puny inventory liquidation. In the first half of 2001, the rate of stock reduction has been the equivalent of 0.2% of nominal GDP. By contrast, back in late 1982 -- when the inventory cycle last worked its magic -- liquidation hit 1.2% of GDP. With stock-to-sales ratios still high and the demand outlook tepid, I see little reason to look for an inventory-led rebound on the production side of the equation.
Nor do I believe that counter-cyclical monetary and fiscal policy will pack their usual punch. In a saving-short, debt-constrained, post-bubble US economy, the Fed has been pushing on a string. The counter to that is "lags" -- the notion that it simply takes time for the medicine to work. After all, the Fed has only been easing for eight months. But the real federal funds rate is still in positive territory, to the tune of about 190 bp (a nominal rate of 350 bp less a TIPS-based inflationary premium of around 160 bp). That’s well in excess of the "zero" real funds rate that the Fed used to jump-start a sagging US economy in the early 1990s. Moreover, as I scan the sectors that typically respond the most to monetary accommodation, I am hard pressed to believe that the lags are about to kick in. That’s especially the case with respect to business capital spending, where the IT-induced capacity overhang seems likely to restrain fixed investment well into 2002, if not beyond. The same can be said for spending on consumer durables, where Ford’s recent layoff announcements pointed more to exhaustion on the motor vehicle demand front than an imminent rebound, in my view. Even the heretofore resilient homebuilding sector may have borrowed from gains in the future, suggesting that the lags of lower interest rates may have already done their thing.
As far as fiscal policy goes, I don’t share the notion that tax rebates pack enough of a punch to counter the fears of job and income insecurity that are about to weigh on the American consumer. And the quickly vanishing budget surplus certainly constrains the Bush Administration from going back to this well again. Similarly, the fallback in energy prices is a plus, but the question is, how big? In his 24 August Forum dispatch, Dick Berner noted that "lower energy prices are adding modestly to discretionary purchasing power." Maybe, but let’s face it, largely thanks to OPEC discipline, world oil prices have remained a good deal firmer than a global recession scenario might otherwise have implied. At the start of this year, when we first warned of worldwide recession risks, we thought that oil prices would fall to $18 by mid-2001. Needless to say, with the price of crude currently holding in the mid-to-upper twenties, the energy-consuming world is not getting the break it needs to offset other contractionary forces now at work in the broader global economy.
Finally, there’s the so-called automatic guarantee of the IT replacement cycle to consider -- the belief that the three-year obsolescence of these sparkling new technologies promises a new wave of product upgrades starting in 2002. I remain deeply suspicious of this vendor-driven hype. In a climate of intense earning compression, there is good reason to believe that corporate managers will become increasingly creative in finding ways to get more life out of the "old" IT platform. That’s certainly the message from our IT department at Morgan Stanley. Moreover, I continue to suspect that a second wave of the IT downturn could well be at hand, this time involving the largely unscathed software portion (see my August 6 essay in Investment Perspectives, "Next Leg of the IT Downturn"). Nor does the latest data flow lend much credence to the view that a bottom may be at hand for the IT cycle: The capital goods piece of the July durable goods report was especially weak, falling at about a 25% annual rate over the past three months and underscoring a deepening of the IT devastation that has long been the defining feature of this downturn.
The case for US economic recovery is also deficient in what it ignores. Two considerations are at the top of my worry list -- the first being the macro implications of this wrenching earnings recession. The cost-cutting response to the earnings carnage is not without significant repercussions -- especially the headcount reductions and compensation adjustments that strike at the heart of the American consumer. I continue to fear that such cost-cutting initiatives will be the predominant force bearing down on the US economy in the second half of 2001 and well into 2002. Secondly, I worry about negative feedback from increasingly depressed overseas markets. Gathering weakness in external demand, together with the lagged impacts of more that six years of dollar appreciation, pose a serious impediment to US export prospects -- undermining yet another source of support for the US economy.
Putting it all together, I still see the glass as at least half empty. Yes, there is a case for a classic cyclical recovery. I would just place a much lower probability on such a possibility than other forecasters. Instead, I continue to favor an "American-style L," with real GDP growth averaging 1.5% over the three years ending in 2002. The good news is that one year of such sluggishness is already under the belt, with US GDP expanding by 1.3% over the four quarters ending in 2Q01. The bad news is that there is probably a good deal more of such unusual sluggishness to come.
As I see it, the outcome over the next couple of years will bear a striking resemblance to the anemic recovery of the early 1990s, when the US economy was bucking the powerful structural headwinds of a banking crisis, a related credit crunch, and a massive wave of corporate restructuring. This time the headwinds will be different -- more reflective of the macro excesses in the real economy that built up during the great equity bubble of the late 1990s. A record current-account deficit, a record shortfall in personal saving, and a massive capacity overhang are at the top of my worry list. In my view, these excesses will need to be purged before vigorous economic growth can once again be sustained in the United States. And that’s likely to take some time -- a good deal more than most investors and analysts are willing to concede. Yes, there can be no mistaking the penchant for optimism that looks at the world quite differently than I do. I guess that’s what makes markets.
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